Here’s something I find mysterious: How is it possible for the central bank to set interest rates? Shouldn’t banks find some way to drag their feet about lending if the rates are too low (or add fees, perhaps) and lower barriers for borrowers if the rates are too high?
Just by controlling incentives. As I understand it the Federal Reserve bank has three tools: the discount rate (the rate at which it loans money to banks), the reserve requirement (how what percentage of a bank’s loans have to be covered by cash on hand) and buying and selling government bonds which correspondingly increase or decrease the money supply. At least that’s the deal with the federal reserve. I can’t say about Europe
So you’re a bank and some one comes in for a loan (representing the marginal loan): Let’s say your cash on hand is right at the reserve requirement. If the requirement is lowered, you can issue loans where you couldn’t before. If the requirement is raised, you can’t issue loans where you could before. As a bank you can borrow money from other banks or from the fed to cover that reserve requirement. But that money is going to cost you. If the interest rate between banks and the discount rate are high, you’re going to have to charge more on loans. If they’re lowered you can charge less.
When rates zero out and banks still won’t lend the central bank can buy government bonds (using money that wasn’t there before). Money get’s devalued, but since wages and prices are sticky that money is worth more to employers and consumers than it is to the bank- increasing the bank’s incentive to lend. The Fed can also sell back bonds which takes money out of the bank, making it more expensive for banks to get money to loan...
There are so-called “liquidity trap scenarios” where banks just want to hang onto the cash and traditional monetary tools are supposed to stop working. But banks can still be influenced by anticipated inflation—if banks think the Fed is about to buy a whole round of new assets, inflating the money supply, devaluing the cash they have on hand, they’ll be looking to lend that money before it loses value. Scott Sumner argues, pretty convincingly, that all monetary policy really is/ought to be about anticipated money supply.
(This is probably oversimplified, I’m not an economist.)
Open market operations (where the Federal Reserve directly buys and sells securities) are the primary means of monetary policy. Borrowing directly from the Fed leads to increased regulatory attention and public skepticism, and so banks avoid doing so except in emergencies. (The discount rate is higher than the rate at which banks lend to each other: If they won’t lend to you then something is wrong). This means the discount rate is relatively unimportant in interest rate targeting outside of emergencies. I don’t understand reserve requirements, but I’m told it’s seen as a fickle way of influencing rates. So buying and selling bonds by the Federal Reserve isn’t the last resort, but rather the favored means of influencing interest rates.
Sometimes, the Federal Reserve does lend directly to banks, at a rate the Fed can set exactly. But this rate is higher than the market rate, and banks avoid borrowing from the Fed unless they’re in trouble and no one else will lend them money. Outside of this situation, the Federal Reserve, (and any other modern central bank), can’t force banks to lend or borrow at a particular rate.
Instead of setting rates by fiat, the Fed will buy and sell bonds and other assets, (printing new money if neccesary) on a public market used by banks to lend to one another. If the Fed wants to lower interest rates, it will buy bonds at higher prices (which means lower yields, which are good for the borrower). By selling bonds to the Fed at higher prices (i.e. getting newly printed money for cheap), a bank can usually lend more at lower interest rates than before. Since banks are competing, no individual bank could really refuse to lower their lending rates unless other banks were also not lowering their rates.
In this way, the Fed can try to influence interests rates without creating incentives for banks to just hoard the money.
Confusingly, the market rate the Federal Reserve is trying to influence is called the “Federal Funds Rate”, while the rate the Fed can set directly is called the “discount rate”.
Here’s something I find mysterious: How is it possible for the central bank to set interest rates? Shouldn’t banks find some way to drag their feet about lending if the rates are too low (or add fees, perhaps) and lower barriers for borrowers if the rates are too high?
Just by controlling incentives. As I understand it the Federal Reserve bank has three tools: the discount rate (the rate at which it loans money to banks), the reserve requirement (how what percentage of a bank’s loans have to be covered by cash on hand) and buying and selling government bonds which correspondingly increase or decrease the money supply. At least that’s the deal with the federal reserve. I can’t say about Europe
So you’re a bank and some one comes in for a loan (representing the marginal loan): Let’s say your cash on hand is right at the reserve requirement. If the requirement is lowered, you can issue loans where you couldn’t before. If the requirement is raised, you can’t issue loans where you could before. As a bank you can borrow money from other banks or from the fed to cover that reserve requirement. But that money is going to cost you. If the interest rate between banks and the discount rate are high, you’re going to have to charge more on loans. If they’re lowered you can charge less.
When rates zero out and banks still won’t lend the central bank can buy government bonds (using money that wasn’t there before). Money get’s devalued, but since wages and prices are sticky that money is worth more to employers and consumers than it is to the bank- increasing the bank’s incentive to lend. The Fed can also sell back bonds which takes money out of the bank, making it more expensive for banks to get money to loan...
There are so-called “liquidity trap scenarios” where banks just want to hang onto the cash and traditional monetary tools are supposed to stop working. But banks can still be influenced by anticipated inflation—if banks think the Fed is about to buy a whole round of new assets, inflating the money supply, devaluing the cash they have on hand, they’ll be looking to lend that money before it loses value. Scott Sumner argues, pretty convincingly, that all monetary policy really is/ought to be about anticipated money supply.
(This is probably oversimplified, I’m not an economist.)
This might be misleading.
Open market operations (where the Federal Reserve directly buys and sells securities) are the primary means of monetary policy. Borrowing directly from the Fed leads to increased regulatory attention and public skepticism, and so banks avoid doing so except in emergencies. (The discount rate is higher than the rate at which banks lend to each other: If they won’t lend to you then something is wrong). This means the discount rate is relatively unimportant in interest rate targeting outside of emergencies. I don’t understand reserve requirements, but I’m told it’s seen as a fickle way of influencing rates. So buying and selling bonds by the Federal Reserve isn’t the last resort, but rather the favored means of influencing interest rates.
This correction seems right. I shouldn’t have phrased the above in terms of priority.
“Set” is an problematic verb here.
Sometimes, the Federal Reserve does lend directly to banks, at a rate the Fed can set exactly. But this rate is higher than the market rate, and banks avoid borrowing from the Fed unless they’re in trouble and no one else will lend them money. Outside of this situation, the Federal Reserve, (and any other modern central bank), can’t force banks to lend or borrow at a particular rate.
Instead of setting rates by fiat, the Fed will buy and sell bonds and other assets, (printing new money if neccesary) on a public market used by banks to lend to one another. If the Fed wants to lower interest rates, it will buy bonds at higher prices (which means lower yields, which are good for the borrower). By selling bonds to the Fed at higher prices (i.e. getting newly printed money for cheap), a bank can usually lend more at lower interest rates than before. Since banks are competing, no individual bank could really refuse to lower their lending rates unless other banks were also not lowering their rates.
In this way, the Fed can try to influence interests rates without creating incentives for banks to just hoard the money.
Confusingly, the market rate the Federal Reserve is trying to influence is called the “Federal Funds Rate”, while the rate the Fed can set directly is called the “discount rate”.
I suspect it has to be with being insured. Also, at some point they do drag their feet, or at least have been accoused of such as of late.